Communiques

The latest compliance news from SEC3 and CCO3.

Exciting Summer Project -- Dig Into Some Sand or Dig Into Your Firm's Best Ex Process?

July 20, 2018

The Office of Compliance Inspections and Examinations (OCIE) issued a risk alert July 11 targeting investment advisers’ most common deficiencies with regard to their best execution obligations under the Investment Advisers Act of 1940 (the “Advisers Act”). The release reflects the results of over 1,500 adviser examinations.

In addition to the 30,000-foot items – inadequate policies and procedures, not performing reviews or otherwise failing to follow policies and procedures – OCIE reminds us of some of the underlying considerations of best execution assessment and brokerage practice disclosure. However, we do not see anything novel in this alert. It is not the first time the SEC has issued a risk alert that appears to contain just reminders without adding new content. For example, last September, the SEC issued an Advertising Risk Alert that was a repeat of old information.

Best Ex Refresher

OCIE reemphasized Advisers’ responsibility to seek best execution taking into consideration the circumstances of the particular transaction and the range and quality of the services provided by the broker-dealer. A key component of fulfilling this obligation is for Advisers to systematically assess the execution quality of broker-dealers used on behalf of their clients and that, while there are a range of potentially valid considerations, some consideration should be given to which factors may be more relevant to the particular trade. For example,

Execution efficiency – for clients with large orders, Advisers may focus on market impact and confidentiality;

Other services –access to research, custody, trading systems, or other efficiencies may play an important role for Advisers in serving their clients.

Some of the areas of deficiency in this regard were found to be inadequate overall due diligence on broker-dealers, a failure to assess any qualitative factors whatsoever during best execution reviews, and failure to incorporate trader and portfolio manager inputs, their perspectives on how a broker-dealer best serves those clients, into the assessment. Another area of deficiency was a failure to seek comparisons from other broker-dealers, a consideration which is particularly important where firms rely predominantly on a single broker-dealer.

The release also emphasizes disclosure in terms of both brokerage practices and soft dollar arrangements. Where certain brokerage practices may present the appearance of a conflict of interest, adequate disclosure calls not only for a clear statement of the practice, but also the conflict introduced by the practice and the potential implications of the practice on clients. This is true whether the potential conflict of interest may be between the firm and its clients, as is the case with soft dollars, or between different groups of an Adviser’s clients, as is the case with a static trade order - where one group of clients systematically trades behind another group.

When OCIE issues risk alerts with new information or as a reminder, it as a warning to firms that this is a priority area for the SEC. Learn from peer deficiencies, take the warning, and re-confirm policies, process and documentation. SEC Compliance Consultants is available to assist you with reviewing your firm’s best execution processes.

SEC Adopts Fund Liquidity Reporting and Disclosure Changes

July 12, 2018

The final week of June was a busy one for SEC releases following the SEC’s June 28th open meeting. Among these was a revisit of Rule 22e-4 under the Investment Company Act, a.k.a. “the Liquidity Rule”, which was originally adopted in October of 2016 in an effort by the SEC to promote effective liquidity risk management and disclosure by open- end mutual funds. On June 28, the SEC adopted changes to the Liquidity Rule affecting periodic reporting on liquidity and the treatment of individual holdings across the liquidity buckets.

Replacing Reporting Requirements

The SEC is rescinding the requirement that funds publicly report aggregate liquidity classification information about their profiles in Form N-PORT. The amended rule will require funds to disclose through a narrative discussion the operation and effectiveness of their liquidity risk management program in their annual or semi-annual shareholder report. This is meant to make the disclosure more accessible and allow the discussion of liquidity risks in the broader context of the factors affecting a fund’s risks, returns, and performance. Under the proposal, this discussion of the operation and effectiveness of a fund’s liquidity risk management program will occupy a new section of the shareholder report following the discussion of board approval of advisory contracts. While the effective date of the rule is September 10, 2018, the SEC wanted to provide additional time so that funds have at least a full year of experience with the liquidity risk management program before including the new narrative disclosure in their shareholder report. The actual compliance date for Large Entities is June 1, 2019 with the first Form N-PORT due July 30, 2019 and the first N-1A due December 1, 2019. The compliance date for Small Entities is March 1, 2020 with the first Form N-Port due April 30, 2020 and the first N-1A due June 1, 2020.

Exemption denied

The Staff noted that several commentators requested an exemption for funds that primarily hold highly liquid investments and In-Kind ETFs due to their significantly lower liquidity risks, arguing that such funds could be exempted from including the proposed new disclosure about their liquidity programs in shareholder reports. However, the SEC was not persuaded, noting that while these highly liquid funds are exempt from certain requirements under the Liquidity Rule, they still must have a liquidity risk management program and that investors would still benefit from the discussion of its operation and effectiveness. The release did note, however, that just as the programs would be scaled to the liquidity risks faced by the fund, so too could the discussion be tailored where programs are less complex.

Satisfying the requirement

To satisfy the disclosure requirement, a fund generally may provide information that was provided to the board about the operation and effectiveness of the program, and insight into how the program functioned over the past year. The discussion should provide investors with enough detail to understand how a fund manages its liquidity risk. Elements suggested in the release include

A discussion of particular liquidity issues that the fund faced during the year (such as a period of high redemptions or illiquidity in particular holdings) and explain how those risks were addressed.

Where a fund faced significant liquidity challenges, a discussion of how those challenges affected the fund.

Additionally, funds may, but are not required to, include

A discussion of the role of the classification process, the 15% illiquid investment limit, or the highly liquid investments in the fund’s liquidity risk management process;

A contextual narrative about how liquidity risk is managed in relation to other investment risks of the fund; and

A discussion of other metrics (spreads, turnover or shareholder concentration issues, as applicable) and their effect on fund liquidity risk management.

The adoption also includes amendments to Form N-PORT designed to help the SEC monitor trends in cash and cash equivalents in the absence of the original aggregate reporting requirement.

Liquidity Buckets

In an effort to address certain difficulties that arise from the requirement to classify each holding into a single category, the Liquidity Rule will allow that each position in a portfolio may be eligible for consideration across multiple category “buckets” under three circumstances:

Where the nature of other positions (e.g., partial coverage by puts) has a potential impact on the liquidity of some portion of the holding;

Where sub-advisers report a common holding in different liquidity buckets; and

Where, for internal risk management purposes, funds classify holdings proportionally across buckets based on an assumed sale of the entire position.

More SEC Settlements - This Time Form PF Filing Deficiencies

June 04, 2018

On June 1st, the SEC announced settlements with 13 RIAs who repeatedly failed to file Form PF reports. Most of these firms never filed over the review period (2012 through 2016). Eleven of them became registered around the same time or after the initial Form PF filing deadline. One of the other two, although initially registered in 2008, never filed Form PF. The last, a firm initially registered in 1981, appears to have made only the initial filing.

These filings - important to the agency for monitoring industry trends, identifying risks, informing rulemaking, and targeting investigations - make for low-hanging fruit and a relatively easy violation to identify when syncing registrants Form PF filings with their private fund reporting on Schedule D, Section 7.B.(1) of Form ADV Part 1A. All 13 matters resulted in settlements with identical penalties of $75,000 regardless of the number of years missed or other varying fact patterns. For each, violations were cited under Advisers Act Rule 204(b)-1, reporting by investment advisers to private funds.

Two Recent Enforcement Actions Against Private Fund Advisers

May 15, 2018

The industry should not misinterpret the SEC’s 2018 National Exam Program Priorities as a shift away from private fund advisers. As discussed during the SEC’s recent National Compliance Outreach Seminar for Investment Companies and Investment Advisers held on April 12, 2018, it is clear that private fund advisers have been “normalized” within the SEC‘s overall priorities with 37% of advisers managing at least one private fund. This is further supported by the broader, cross-section of private fund investors including 25% pensions, 11% individuals and 10% non-profits . For various reasons, including the broad authority private fund advisers (or their affiliates) have over the day-to-day operations of a private fund, expense allocation, revenue streams and valuation will always be focus areas during any routine examination of a private fund adviser.

When an asset manager’s secret sauce leaves a bad taste with investors in terms of poor performance, significant redemptions can follow. Below are two recent examples where the private fund adviser’s subsequent actions burnt their kitchens down. Last week, the SEC issued press releases involving serious misconduct by two private fund advisers including a failure to supervise settlement with the CFO of one of the advisers.

Visium Asset Management

On May 8th the SEC announced that Visium Asset Management, a hedge fund advisory firm, agreed to settle charges related to mispricing assets and insider trading. Separately, the firm’s CFO agreed to settle charges that he failed to supervise the portfolio managers involved when, according to the SEC, there were a number of red flags that should have alerted the CFO to the asset mispricing.

The SEC claims two portfolio managers at the firm inflated the value of securities held by its hedge funds, resulting in $3.15 million in excess fees earned by the adviser. The SEC’s settlement with the CFO claims the CFO failed to supervise the portfolio managers as a result of not recognizing certain red flags including an excessive number of valuation over-rides that, more often than not, resulted in higher asset prices. The order involving the firm, found that certain portfolio managers traded in securities based on material non-public information gleaned from insiders working as paid consultants to the firm.

It is unclear exactly why the CCO was not named. We do know the SEC noted that Visium’s policies and procedures were:

“…reasonably designed to prevent the misuse, of material, nonpublic information by the firm and persons associated with it. Visium’s written policies and procedures concerning prevention of the misuse of material, nonpublic information were contained in its compliance manuals in effect at the relevant time. The policies prohibited employees from trading on any material, nonpublic information they obtained in the course of their employment, and listed types of information that could constitute material, nonpublic information. The policies also instructed employees to alert the Chief Compliance Officer (“CCO”) if there was a possibility information they obtained was material, nonpublic information, or if they had any questions about whether information they obtained was material, nonpublic information. Each employee was required to review Visium’s insider trading policies and procedures and to sign an acknowledgement that, among other things, he or she was prohibited from trading on the basis of material, nonpublic information. The procedures also addressed the use of outside consultants. Specifically, a “Checklist Resolving Issues Concerning Insider Trading” recommended, among other things, that employees should (a) ensure all agreements with third-party research consultants contain an insider trading prohibition disclosure, and (b) remind consultants that Visium should not be a recipient of actual or potential material, nonpublic information.”

However, the SEC does state that Visium 1--had inadequate measures in place to enforce its policies and to ensure the Checklist was followed, and 2--took inadequate steps to monitor employees’ communications with consultants.

While we do not have enough information concerning the CCO’s role in this case and Visium’s supervisory structure, every CCO should carefully examine their own firm’s supervisory structure and ensure that it is explicit in all compliance areas. CCOs are not required to be supervisors. CCOs should consider ensuring knowledgeable persons are clearly defined as supervisors and those supervisors understand their obligations.

Premium Point Investments

On May 9th the SEC announced that it has charged investment adviser Premium Point Investments with fraudulently inflating the value of its private funds by hundreds of millions of dollars. The SEC also charged the CEO/CIO, a former partner/PM, and a former trader.

According to the SEC complaint, Premium Point was operating two schemes to inflate valuations. The more recent scheme, which ran from at least September 2015 through March 2016, during a period of poor performance and requests from large investors to redeem, involved a secret deal where, in exchange for sending trades to a broker-dealer, the adviser received inflated broker quotes from the broker-dealer for certain mortgage-backed securities which the SEC alleges were used to inflate the value of holdings, exaggerating returns. The longer running scheme involved Premium Point’s undisclosed policy of using “imputed” mid-point prices of securities even when actual mid-point prices were available and since 2015 included the “fixed” broker-quote to calculate the “imputed” values. The SEC also took exception to the fact that Premium Point mislead a prospect in 2011 who said they would not invest if Premium Point used “imputed” mid-points to value securities. Based on representations by Premium Point that imputed values would not be used, the prospect invested, and Premium Point used “imputed” mid-points.

The SEC’s complaint charges the defendants with fraud and/or aiding and abetting fraud, and seeks permanent injunctions, return of allegedly ill-gotten gains with interest, and civil penalties. No person in the complaint was identified as a compliance professional.

All advisers should interpret the National Exam Program’s annual priority list as “additional” focus areas. Private fund advisers are often viewed by examiners as having a business model where potential “higher-risk” activities may exist. The SEC typically will focus on those higher risk areas when examining private fund advisers and want to ensure adequate policies and procedures are in place.

2018 - Are you ready for your next SEC exam?

March 19, 2018

The pool of registered investment advisers that will be subject to an SEC exam in 2018 is at the highest level seen in years. The SEC projects it will examine 15% of the RIA population. A 40% uptick in IA exams makes it even more paramount that you be ever-prepared should your firm get the call.

Being prepared for an SEC exam makes all the difference in the direction an exam could take; especially with the SEC’s risk-based approach. The SEC takes a risk-based approach to almost all exams. Given this, firms have a bit more control in whether or not an exam can be closed quicker.

We are seeing that registrants have more control now than in the past with respect to controlling an exam.

This Wednesday, March 21, 2018, Janaya Moscony will team up with Mark Dowdell, Assistant Director, Philadelphia Regional Office and Shelley Sims, General Counsel/CCO, FIS Group Inc., in kicking off the 20th Annual IA Compliance Conference.

The panel will be sharing insights into what to do before examiners arrive to ensure you are ready for an exam. You can expect to hear the SEC’s “Top 10” focus areas, the items being sought in current document requests letters and the tried and true exam prep techniques that have served your peers who have been through a recent exam well.

Janaya will discuss SEC3’s Exam Tips for firms to consider when dealing with an SEC exam in today’s regulatory environment.

SEC3 friends wishing to attend can utilize the discount code SPEAKER300 and this will entitle you to a $300 discount when you register for the conference. As always, feel free to please reach out to us if you have questions on how to frame an exam and get the examiners in and out of your business as swiftly as possible.

Navigating the Changes to Form ADV

January 12, 2018

On August 25, 2016, the U.S. Securities and Exchange Commission adopted numerous substantive and technical amendments to Form ADV. While the adopting release required advisers to begin complying with the amendments as of October 1, 2017, most advisers will only be considering these changes in Q1 of 2018 as they prepare their annual ADV amendments. Some of the ADV disclosure changes are relatively simple, but others are trickier to assess.

The majority of advisers will generally need to expand their disclosure related, for example, to social media platforms used for firm business, the number of offices, and whether the firm engages an outsourced CCO. However, separate account managers will notice significantly more disclosure requirements of their separately managed accounts including information related to categories of investments, borrowings, derivative exposure, and custodians. In addition, private fund advisers should be aware that while the conditions set forth in the 2012 ABA No-Action Letter for assessing whether an adviser can use an umbrella registration have not changed, the disclosure required for relying advisers has been expanded.

There are several other clarifying and technical amendments to assess as you initiate your annual ADV update this year. As you go through the new Form ADV, feel free to reach out if you need assistance.

Overlooked Benefits of E&O/D&O

December 13, 2017

While asset managers should always be aware of the protections provided by their E&O/ D&O coverage, there are more reasons than ever to think about it now.

The SEC continues to push forward stressing individual accountability by taking action against individuals. In its 2017 fiscal report, the SEC’s Enforcement Division cites individual accountability as one of its core enforcement principles. Since Clayton took the helm as SEC Chairman, we have seen that the SEC continues to name individuals in most cases.

Investors will continue to take action against firms when they suspect they can recoup losses.

Most insurance companies are now offering a premium credit or reimbursement to firms conducting mock audits so it’s not completely “out-of-pocket”.

You can request a free assessment of your current policy to identify gaps where you may need additional coverage AND where you may be able to add the coverage with little to no additional premium.

While compliance is of course our forte, we view insurance as just one necessary control to help mitigate your risks.

This January, Janaya Moscony, president of SEC3, was interviewed by Julie DiMauro - Thomson Reuters.

CCO Liability (Part III): Managing Liability Webinar

In this webinar, panelists discuss indemnifications and insurance as potential remedies to address the direct financial risks to a CCO.

Listeners will learn:

What terms and conditions should Chief Compliance Officers be aware of with respect to insurance policies and riders?

Are CCOs still covered once they leave a firm?

What factors may a board wish to consider in connection with approving or renewing a D&O/E&O insurance policy?

What are the protections/defenses in place for fund directors? Are CCOs afforded the same protections? Also, is outside counsel ever subject to potential liability?

Are Fund Directors ever found personally liable or are they covered by fund assets and/or D&O/E&O insurance policies?

What is the biggest misconception about cyber insurance?

Wishing One-and-All a Happy, Healthy and Prosperous New Year

December 29, 2016

We hope each of you found some peace and tranquility in the company of loved ones this holiday season and want to wish one-and-all a happy, healthy and prosperous New Year.

As the lights dim on 2016, we naturally want to prophesy 2017. However, with so much friction, division and uncertainty in our world, most predictions would be at best – a good guess. As such, we will leave such predictions to others, whether it be geopolitical, country-specific or related to the financial services industry, and will enjoy tracking other’s soothsaying. Instead, at this time, we believe it is best to be guided by a strong moral compass, focus on what we know, learn about what we don’t know, remain vigilant to our surroundings and adjust as necessary.

In June, we shared our thoughts around common insurance gaps and insurance riders that CCOs as well as managers should understand. One of the gaps we shared related to pre-claim defense costs. In August, a court ruled on behalf of an insurer in that they were not required to cover the insured for costs related to investigations prior to the Issuance of a Wells notice.

Communiques

The Office of Compliance Inspections and Examinations (OCIE) issued a risk alert July 11 targeting investment advisers’ most common deficiencies with regard to their best execution obligations under the Investment... read more »

The industry should not misinterpret the SEC’s 2018 National Exam Program Priorities as a shift away from private fund advisers. As discussed during the SEC’s recent National Compliance Outreach Seminar... read more »

On August 25, 2016, the U.S. Securities and Exchange Commission adopted numerous substantive and technical amendments to Form ADV. While the adopting release required advisers to begin complying with the... read more »

In this webinar, panelists discuss indemnifications and insurance as potential remedies to address the direct financial risks to a CCO.
Attendees will learn:
What terms and conditions should Chief Compliance Officers be...